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Corporate Governance Group December 29, 2008 Corporate Governance Group Client Alert BEIJING FRANK F URT HONG KONG LONDON LOS ANGE L ES MUNIC H NEW YORK SINGAPORE TOK Y O WAS H INGTON , DC Please feel free to discuss any aspect of this Client NY STATE COURT DECISION Alert with your regular Milbank contacts or with RELATING TO BEAR STEARNS any of the members of our Corporate Governance TAKEOVER SHOULD PROVIDE Group, whose names and contact information are COMFORT TO CORPORATE provided herein. DIRECTORS FORCED TO TAKE In addition, if you would like copies of our other ACTION IN UNSTABLE MARKETS Client Alerts, please contact any of the attorneys listed. You can also obtain this Court Defers to Business Judgment of Bear Stearns Directors and our other Client Alerts by visiting our website at in Connection with JP Morgan Merger http://www.milbank.com and choosing the “Client On December 4, 2008, in In re Bear Stearns Litigation,1 the New York Supreme Alerts & Newsletters” link under “Newsroom/ Court dismissed investor challenges to the federally-assisted acquisition of Bear Events”. Stearns by JPMorgan Chase. To our knowledge, this is the first judicial decision in the spate of shareholder class action lawsuits brought in the wake of the unprecedented meltdown of many of our leading financial institutions during 2008. The plaintiffs This Client Alert is in this class action, former Bear Stearns shareholders, sought (among other relief) a source of general damages from Bear Stearns’ directors for alleged violation of their fiduciary duties information for clients and in negotiating and approving the merger with JP Morgan. Relying on the business friends of Milbank, Tweed, judgment rule’s “presumption that in making a business decision, the directors of a Hadley & McCloy LLP. Its content should not be corporation acted on an informed basis, in good faith and in the honest belief that the construed as legal advice, action taken was in the best interest of the company,” Judge Cahn granted the director and readers should not act defendants’ motion for summary judgment, determining that the Court “should not, upon the information in and will not, second guess their decision.” this Client Alert without consulting counsel. The Court’s decision repeatedly emphasizes the unprecedented and dire straits in © 2008, Milbank, Tweed, which the Bear Stearns directors found themselves, characterizing their actions as an Hadley & McCloy LLP. attempt “to salvage some $1.5 billion in shareholder value and [avert] a bankruptcy All rights reserved. that may have returned nothing to the Bear Stearns’ shareholders, while wreaking havoc on the financial markets.” Given the gravity of the circumstances, and recognizing that this was a New York state court applying and interpreting Delaware law, the Bear Stearns ruling may have limited precedential value when the financial 1 In re Bear Stearns Litigation, N.Y. Sup. Ct., Index No. 600780/08 12/4/08. Corporate Governance Group markets rebound. But it surely should be comforting to corporate directors forced to make difficult, and sometimes rushed, decisions in the current environment that courts remain willing to defer to the directors’ business judgment. Background The facts of Bear Stearns’ fall from grace are by now well known. During the week beginning Monday, March 10, 2008, Moody’s downgraded certain mortgage-backed debt issued by a Bear Stearns affiliate. As rumors concerning Bear Stearns’ liquidity and ability to continue in business flooded the marketplace, Bear Stearns customers began withdrawing billions of dollars and counterparties refused to continue doing business with the company. By the weekend, with the stock price plummeting and the company’s financial condition deteriorating rapidly, Bear Stearns determined that, without a stabilizing transaction or a bankruptcy filing, it would not be able to open for business on Monday morning. In response to continued pressure from federal regulators and an inability to obtain any alternate financing,2 on Sunday, March 16, 2008, the board of directors of Bear Stearns approved a stock-for-stock merger with JPMorgan pursuant to which Bear Stearns shareholders would receive $2 of JP Morgan stock for each of their Bear Stearns shares.3 The merger agreement negotiated by Bear Stearns and JP Morgan contained a number of provisions aimed at providing deal certainty for JP Morgan, including (i) an option for JP Morgan to purchase 19.9% of Bear Stearns’ stock at $2 per share, (ii) an option for JP Morgan to purchase the Bear Stearns headquarters for $1.1 billion and (iii) an agreement on the part of Bear Stearns not to solicit competing proposals. Following an outcry from Bear Stearns shareholders which raised the specter that they would not approve the transaction, the merger agreement was amended a week later to raise the merger consideration to $10 of JP Morgan stock for each Bear Stearns share.4 In addition, JP Morgan was given the right to purchase a 39.5% interest in Bear Stearns at $10 per share and the Bear Stearns directors agreed to resign at the effective time of the merger.5 Subsequently, JP Morgan purchased an additional 10% of the outstanding Bear Stearns shares on the open market, lifting its stake to 49.5%. On May 29, 2008, the merger was approved by Bear Stearns’ shareholders by a 71% vote.6 The Court Applies the Business Judgment Rule The Court began its analysis of plaintiffs’ breach of fiduciary duty claim by tackling the threshold determination of the appropriate standard of review. The Court concluded that the least stringent standard of review, Delaware’s business judgment rule, should be applied. In so ruling, the Court rejected plaintiffs’ arguments for a heightened level of scrutiny of the board’s actions – and particularly the deal protection devices negotiated with JP Morgan – under either Unocal,7 Blasius8 or Revlon9: 2 During this period, Lazard solicited over a dozen potential merger partners for Bear Stearns, but ultimately only JP Morgan was in a position to move with the necessary speed and obtain the backing of the federal government. 3 In addition, JP Morgan agreed to guarantee immediately various obligations of Bear Stearns, and the New York Fed agreed to provide supplemental funding of up to $30 billion. 4 JP Morgan was particularly concerned by this development since its guarantee of Bear Stearns’ obligations, as drafted, continued for a year even if Bear Stearns shareholders rejected the transaction and the merger agreement terminated. 5 In addition, although the amended arrangements reduced the period of JP Morgan’s continuing guarantee to 120 days if the transaction was not completed, JP Morgan was forced by the NY Fed to guarantee Bear Stearns’ borrowings from the NY Fed and to assume up to the first $1 billion of any losses suffered by the NY Fed on its $30 billion loan to the company. 6 Had the 39.5% block of shares purchased by JP Morgan been excluded from the vote, the merger still would have passed with 52% of the vote; however, if all shares owned by JP Morgan shares were excluded, the transaction would have failed with a 42.7% vote. 7 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1995). 8 Blasius Indus, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988). 9 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986). 2 Corporate Governance Group With respect to Unocal, the Court noted that Unocal typically applies if an external hostile threat to corporate control had been initiated by a third party, but not in a case (such as this) where “the board initiates the transaction in the absence of such an external threat.” It should be noted that this line of reasoning is clearly at odds with a number of Delaware cases in which courts have applied a Unocal analysis to deal protection devices included in merger agreements. Next, with respect to Blasius, the Court noted that “its application has been largely limited to disputes over the election of directors” and that “the reasoning of Blasius is far less powerful when the matter up for consideration has little or no bearing on whether the directors will continue in office.” Continuing in this vein, the Court found no evidence that the “directors’ primary purpose in approaching the merger was to affect the shareholder franchise.” Finally, with respect to Revlon, the Court stated that “Revlon duties are not ordinarily implicated in a stock-for-stock merger of widely-held public companies,” and that neither the issuance of a 39.5% block of shares to JPMorgan nor its subsequent purchase of an additional 10% on the open market constituted a transfer of control. “Rather,” the Court noted, “the public shareholders retained ultimate control.” Because, in the Court’s view, the plaintiffs “failed to establish that a heightened standard of review should be applied,” the Court invoked the business judgment rule, thereby placing the burden on the plaintiffs to demonstrate a breach of the duty of care or loyalty, or bad faith action, on the part of the Bear Stearns directors.10 In this regard, the Court concluded that there was “no evidence that the board – comprised of a majority of non- management, non-employee directors and assisted by teams of financial and legal advisers – acted out of self- interest or bad faith.” Moreover, the Court refused to give credence to expert opinions obtained by the plaintiffs, noting that they did “not take into sufficient consideration the very real emergency which the company faced, and the real time pressure under which Bear Stearns’ officers and directors were operating. The company could simply not continue to carry on its major operations on Monday morning, unless it had put some major financing, or a major transaction which would carry with it major financing, in place.
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